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Climate change and the global economy: growth and inflation

In the first of a series of four articles, Keith Wade and Marcus Jennings examine the effect of climate change on global growth and inflation.

21/07/2015

Keith Wade

Chief Economist & Strategist

Marcus Jennings

Economist

Assessing the impact of climate change is, at best, an extremely complex exercise with uncertainty about both the degree of future global warming and the subsequent impact on global activity.

There are clearly some benefits as well as costs as the planet warms. There is also the unknown of how technological progress will respond and potentially alter the path of global warming.

Any assessment also involves taking a very long-run view, well beyond that normally used by financial market participants.

However, increasing awareness of the issue means there is a growing demand for a view from shareholders who are either concerned about how the companies they own impact the environment, worried about the effect of climate change on the value chain of those companies, or a combination of both.

In response, the academic community is leading the way in an attempt to encourage financial market participants and governments alike to change collective behaviour so as to mitigate the costs of global warming. Drawing on this work, we discuss, in a series of four articles:

The effect on global growth and inflation,

The different climate loss functions (these attempt to estimate the economic cost associated with a given increase in temperature)

The regional effects of climate change

The possible policy responses.

The effect on growth and inflation

The overall aggregate effect of climate change on economic growth will most likely be negative in the long run.

Although there will be winners and losers from climate change at varying levels of warming, the impact of rising temperatures will be widespread, in part due to the financial, political and economic integration of the world's economies.

Global warming will primarily influence economic growth through:

Damage to property and infrastructure

Lost productivity

Mass migration

Security threats.

The balance between winners and losers turns increasingly negative as temperatures rise.

The damaging effects on stock levels

Global warming is expected to increase the frequency and severity of extreme weather events, bringing with it property and infrastructure loss.

The likes of Hurricane Sandy, which flooded much of New York, is a prime example of the economic damage such extreme weather events can cause.

Rising sea levels will also likely harm economic output as businesses become impaired and people suffer damage to their homes.

Whilst the initial economic response to recover this damage may be positive for GDP (when it is possible to do so), once it is recognised that such events are a permanent feature of the environment, the world economy faces an extreme challenge.

Many will find that it is not worth replacing capital stock unless measures can be taken to prevent future damage, or there is an opportunity to move the business to safer ground.

At best, this could involve a short period of disruption as businesses relocate; at worst, a permanent loss of capital stock and output. As the temperatures continue to climb, the damage will become increasingly permanent.

Climate change is likely to reduce the capital stock and productivity in the world economy

Using a production function (Figure 1), we can demonstrate the likely effect climate change will have on output.

Figure 1: Global production function

If we assume less capital stock is available due to the damage inflicted from climate change, we would see a fall in the productive capacity of the world economy.

This would translate into a downward shift in the world production function as each unit of labour produces less output.

Lower labour productivity may not just occur due to a lower level of capital stock, however.

Higher global temperatures may affect food security, promote the spread of infectious diseases and impair those working outdoors.

Such factors are likely to cause greater incapacity and social unrest and as a result will reduce both the effectiveness (productivity) and the amount of labour available to produce output.

This effect can also be expressed as a supply shock through a supply and demand framework (Figure 2).

Figure 2: Supply and demand effects

Global warming is likely to contract supply at any given price and result in a backward shift of the supply curve (from S1 to S2). As the diagram demonstrates, this will result in a lower level of output (Y2) and, as we discuss in the next section, a higher price (P2).

There is also an opportunity cost to be considered.

The above analysis is based on an "all else equal" argument whereby the world's population is seen not to respond to climate change.

It is probable that over time, preventative measures such as flood defences are put in place in order to avoid the costs of climate change.

Whilst this may reduce the long-term economic consequences, there is likely to be a short-term economic cost to this action as resources are directed away from more productive uses.

According to Mendelsohn (2013,"Climate Change and Economic Growth, Commission on Growth and Development", Working paper no.60), the biggest threat climate change poses to economic growth is from immediate, aggressive and inefficient mitigation policies.

The process of adaptation and mitigation will require a temporary economic transition from consumption to investment, with the argument being that the transitional costs are small relative to the cost of inaction. Stern (2006, "Stern Review on The Economics of Climate Change (pre-publication edition). Executive Summary", HM Treasury, London. Archived from the original on 31 January 2010) estimates the costs of mitigation to be in the region of 1% of global GDP per annum by 2050.

However, we would argue that as the costs of mitigation rise, budget constraints are likely to become increasingly important. Governments’ may be unable to raise the capital necessary to build adequate defences, for example.

Beware of rising inflation

The above supply and demand diagram not only shows a reduction in output, but an increase in the general price level as a result of global warming.

This leads us onto the possible inflationary effects of global warming on the world economy.

Agricultural yields are sensitive to weather conditions and as our climate becomes ever more extreme, more frequent droughts may reduce crop yields in areas where food production is vital.

Higher global food prices will likely thus squeeze consumers’ income in the process.

We must acknowledge that these effects will be partially offset as other regions becoming more suitable for crop production and new drought resistant crops are developed.

However, in aggregate, and as the level of warming becomes even greater, food price inflation should rise.

Rising inflation may also materialise through reduced land availability.

The surge in global temperatures may eventually cause some areas of the world to become inhabitable and with this will come mass migration.

Alongside the political and socioeconomic implications of these moves will be higher demand for an ever decreasing amount of land.

In essence, the world's population will be forced to live in an increasingly concentrated space.

In similar fashion to food inflation however, this effect will also be moderated by some areas of land becoming more habitable (see regional effect section below).

Increasing energy costs

Higher energy costs are also likely to boost inflation.

As our climate become more extreme we are likely to demand greater energy to both cool our working and living environments during the summer, and heat them when we experience harsher winters.

Not only will energy demand change, but supply may shrink as the efficiency of existing power stations is compromised due to higher temperatures.

Policy actions by governments to encourage a transition to green energy may further contribute to energy inflation in the short- to medium-term whereby taxes are placed on fossil fuel-derived electricity.

Given that energy forms the basis of most of the world’s production, the secondary effects of higher energy prices on inflation will be felt throughout the global economy.

Conversely, depending on the pace of change, the greater prominence of renewable energy could limit the cost of energy increases going forward.

Insurance premiums at risk

The insurance industry recognises that they are likely to bear much of the risk of global warming.

Companies have already felt the force of extreme weather events on profits; from unseasonal floods in the UK to Hurricane Katrina in the US, extreme weather-related damage to properties has seen insurance companies pay out to cover these costs.

It is believed that 2011 was the most expensive year on record for natural disasters, with insured losses costing the industry more than $126 billion.

The Governor of the Bank of England, Mark Carney, commenting on the research the Bank has conducted recently, stated that climate change is one of the top risks faced by the insurance industry.

The industry has been at the forefront of assessing climate risk, and as a consequence, the costs of global warming could be felt earlier than expected in the form of higher premiums.

We are already seeing a curtailment of available cover in areas such as Florida and many Gulf coast states for example.

The cost of flood insurance has risen significantly in the UK. Rising insurance costs add to inflation and will deter firms and households from locating in areas at risk.

Insurance companies may go as far as to refuse to provide insurance cover, raising a challenge for governments who may either have to underwrite, and/or mitigate the risk of damage.

From this perspective, the costs of climate change are already being incorporated into business decisions and in this way are already affecting global activity.

Related content

We surveyed economists at investment banks regarding the impact of climate change on the world economy. The results supported our own analysis that climate change represents a significant threat and will likely be inflationary, while short-termism hampers mitigation efforts.

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